What to Know Before You Invest in Startups

Depending on certain factors, it could be a great idea to put some portion of your portfolio into high risk assets like startups. But before you do, there are three major factors you need to consider to make sure start-up investing is appropriate for you.
This post was published on the now-closed HuffPost Contributor platform. Contributors control their own work and posted freely to our site. If you need to flag this entry as abusive, send us an email.

The last decade has seen the rise of the startup, both in the financial and popular press. We all know the success stories; Uber, AirBnB, Twitter, and others have gone from nothing to multi-billion dollar valuations in extremely short periods. And they were funded, in part, by angel investors who gained immensely from their success.

Because of this attention, and with new regulations like the JOBS Act and the rise of platforms, like MicroVentures, that facilitate equity crowdfunding and angel investing online, more people than ever are thinking about investing in startups.

While startup investing is risky, it also provides the possibility for outsized returns (anywhere from five to 100 times your initial investment) when compared to other asset classes. Depending on certain factors, it could be a great idea to put some portion of your portfolio into high risk assets like startups. But before you do, there are three major factors you need to consider to make sure start-up investing is appropriate for you.

1) Risk: What is your risk tolerance? Can you afford to lose your money?

Public markets are diverse so it is relatively easier to find investment vehicles that match your risk tolerance. You can invest in bonds, treasuries, blue chip companies with long histories and other more stable investments and possibly alongside IPOs and other companies that are more speculative.

Startups are a whole different breed. The winners tend to win big, but most fail. And when they fail, you almost never get any money back. It's gone, along with the company.

Before you think about getting into this kind of investing, you must ask some questions: Are you a conservative investor? Do you want to minimize risk and see some kind of underlying asset backing an investment? Or are you the type of person who's willing to take risks and lose it all?

If you're on the conservative end of the spectrum, startup investing is NOT for you. Startup investing is only right for people who want to take big risks (and potentially lose all their money) in exchange for the low probability of huge rewards.

This being said, even though startups require a high risk tolerance, you can mitigate some of the risk inherent to investing in early stage companies. Early stage companies with just an idea carry the biggest risk. However, you can also find companies that have both an idea and a prototype (or something else tangible that you can see) and even a company with traction with a clear path to revenue, or a seasoned executive team with a history of finding ways to generate business.

The other way to mitigate risk is by not investing all your money in one company. You can spread it around, aka diversification. Ron Conway used a method that outsider used to refer to a "spray and pray" that's still popular today. He would invest in hundreds of early stage companies and then make followon investments in the ones that began to gain traction. He didn't just invest in every startup that came his way though. He made intelligent decisions based on factors including how unique the idea was and if the team in place could execute on that idea.

You may not have the level of sophistication and network that Ron Conway has, but with the rise of crowdfunding and angel investing platforms, building your own venture capital portfolio is now truly possible. Before the rise of platforms like MicroVentures and Angellist, investing in startups required a large upfront commitment of capital. With $50K, you could only invest in one or two companies as a typical "angel."

Since these online platforms allow companies to more easily raise money from larger groups of people, you can now invest in ten or more companies with that same $50K of available capital. When three out of four startups are destined to fail, you want to put your money into as many different companies as possible to maximize your chances of success. This ability to diversify your risk across multiple startups is unique to these platforms, and can't be replicated by just investing in small businesses your friends start.

The great thing about angel investing is that one or two winners could pay off all of your other investments and then some. With a portfolio of only two or three investments, the likelihood of finding these big winners drops significantly.

2. Time: Do you need access to your money? When?

Startups are much less liquid than other types of investments. Generally, the only way you're going to see a return on your investment is after the company has a liquidity event or exit. To understand how long that might take, you need to understand the exit strategy of the startup in which you're investing. Do the founders want to go for an IPO? That could take 10 to 15 years. Do they want to build traction and get acquired by a bigger company? Or do they want to keep the company private and run it themselves for a long period of time.

Not only do you need to understand what kind of exit the startup's team wants but also whether that strategy is actually feasible. If the startup wants to be acquired, are there companies out there for whom it makes strategic sense to make the acquisition? Even if a startup looks like a good acquisition candidate, the larger company may choose to just rip them off. Facebook acquired Instagram for $1 billion dollars, but when it came to dealing with the threat from Snapchat, Facebook decided to build their own version called Poke.

All of this comes back to the question of when you would like to see a return on your money. Is it two to three years or seven plus years? If you need money in the two to three year range, you need to look at late-stage companies on the secondary market that are in the pre-IPO phase. We saw investors generate returns investing in Yelp, Facebook, and Twitter on our platform during their run-ups to IPO. If you look around right now, there are several more opportunities available that could repeat that success: Uber, airbnb, Box and Dropbox to name a few (you can look at some of these types of investments on our site if you'd like to get a sense for what they look like).

But generally speaking, the only money you should invest in startups is money that you don't need to use for another purpose for at least the next five to seven years, and ideally 10+. If you need your money to produce significant returns within a short timeframe, with low risk, you shouldn't be investing in startups at all.

3. Expertise: Do you have the business experience to evaluate companies and markets?

The best startup investors apply their own operational business experiences to make the best investment choices. The more time you've spent in a startup or running your own business or even working for an existing company, the better you will understand the aspects of business a startup needs to master. You will also be better equipped to identify whether the startup is, in fact, mastering them. If you are a more cautious investor who needs more data points before making an investment decision, it might make sense to begin only with startups in industries where you have worked the longest or spent the most time.

If you're someone who works at Google or Apple or even does independent mobile software development you probably understand that specific space better than most other people. You know what goes into acquiring new customers, what customers look for, how to build apps, and understand both the mechanics and levels of competition in an app store. When dealing with an industry you understand, it's much easier to answer questions like: Does this company have a good idea that can actually work? Do they have a business plan that makes sense? And does the team have the necessary skills and experience to execute on that plan?

However, if you're looking at a company that's outside your wheelhouse, maybe some sort of medical technology company, you probably don't know how to assess it accurately. The idea may sound amazing and have world changing potential, but without the background to truly analyze the market it is very hard to do an accurate risk assessment. This doesn't mean you shouldn't invest in those types of companies though. If you have properly diversified investments in multiple startups, strategically you should be able to handle the risk by putting less money into these types of companies and more into the startups from industries you understand.

If you think you're the type of person with the means and ability to invest in startups, this is only the beginning of your journey. There's still plenty more to consider. Ultimately, investing in startups can be overwhelming for new investors. Besides offering risky bets on companies, many platforms make the situation worse by offering little or no guidance for investors. They might have exciting offerings -- but that excitement can mask potentially unsound deals. On the other hand, typical discount brokerages are not able to give their investors access to exciting and lucrative opportunities like Facebook or Twitter until those deals are available to all investors via an IPO.

This space is going to change a lot in the future. If you've got the right appetite for risk, for playing the long game and bring domain expertise to the table, then startup investing could be worth exploring.

'Have No Regrets' --Richard Branson, Founder of Virgin Group

The Best Advice I Ever Got


HuffPost Shopping’s Best Finds